Portfolio Management

• Standard Deviation

  Square root of the variance

  • Measures dispersion from the mean

  Problem: Market returns are negatively skewed, not normally distributed

  
• Semi-Variance

  Variance of returns below the mean

  • Hence, a better measure of DOWNSIDE risk
• Shortfall

  Probability: Chance of returns falling below a target level

  Expected: Expected loss at a given probability
• Value at Risk (VaR)

  Estimates the size of losses at a given frequency

  E.G., £10 2.5%, the loss for a -2std. move

  • Historical Return Approach (ex-post)

  OR

  • Monte Carlo scenario analysis (ex-ante)
• Drawdown

  Decline from peak value over a given timeframe (ex-post)
• Tracking error

  Standard deviation of the surplus return to benchmark (also known as active risk)

  • Manager's risk
• Portfolio Dominance

  Occurs when comparing portfolio to the benchmark, and the portfolio has ether higher returns for the same risk, or same returns for lower risk
• Total risk

  Risk = Unsystematic + Systematic Risk

  • Unsystematic risk can be diversified away with the number of securities in a portfolio

  
• Correlation Coefficient

  Correlation coefficient gives the correlations between asset classes

  It is a measure of the strength of the relationship between two variables

  It is: r=Cov(X,Y) / Std(X)Std(Y)
• Correlation Convergance

  Correlations converge to +1 in extreme market conditions

  • Efficient portfolios aim to decrease correlations
• CAPM

  Capital Asset Pricing Model

  A) Minimum required return on the portfolio

  B) Risk free rate

  C) Beta: Cov(P,M)/Var(M)

  D) Market Returns

  
• CAPM Assumptions

  1. perfectly competitive markets
  2. Homogeneous investors
  3. Unlimited borrowing/lending at risk free rate
  4. Rational investors
• Beta

  A measure of systematic risk of the portfolio relative to the market portfolio (or benchmark index)

  • Beta = Cov(Rp,Rm) / Var(Rm)

  The benchmark has a beta of 1

  A portfolio beta weights individual securities' betas accordingly
• Efficient Markets Hypothesis

  Fama French (2003)

  • That all securities prices will instantly reflect all available information

  Weak Form: Prices reflect past information, so technical analysis is fruitless.

  Semi-Strong Form:Prices reflect all past and public information

  Strong-Form: Prices reflect all relevant information
• Conditions for EMH

  1. Investors are rational and homogeneous
• Behavioural Finance

  Biases:

  • Memory bias
  • Overconfidence (hubris)
  • Confirmation bias
  • Conservatism bias
  • Sample size neglect
  • Endowment effect
  • Prospect theory / loss aversion
  • Anchoring
  • Herd behaviour
• Prospect Theory

  Individuals assess their gains and losses asymmetrically
• Financial Amnesia

  Asset bubbles

  • Forgetting the past events
• Fair Value

  Estimating Fair Value:

  • Liquid markets: Quoted prices from active markets
  • Illiquid markets: Similar assets, assumptions, or estimates

  Less preferred to measure fair value on assumptions, as these can be under-reported
• Strategic Asset Allocation

  Top-down approach is to choose the asset classes and allocations first, and leave individual stock picking until last

  Bottom-up approach is to use fundamental analysis and construct a portfolio of stocks, not allocations
• Passive Funds

  • Tracker funds
  • Low cost
  • Low tracking error
• Active Funds

  • Seeking mispriced opportunities
  • More concentrated downside risk
  • Higher costs
• Portfolio Tilting

  A combination of active and passive fund management
• Growth Portfolios

  Securities with above average PE ratios, and high growth prospects

  • Momentum investing (previous 6 months)
• Value Portfolios

  Undervalued securities with high yields

  Stock-market contrarian
• Cash Matching

  Purchasing bonds so that the cash flows in match the cash outflows

  e.g., coupons and principal match pensions

  • No reinvestment or interest rate risk
• Duration and Immunisation

  Matching the duration of the portfolio with the liability duration

  • The portfolio is immunised from change in interest rates
  • Bonds are sold at their duration rather than held to redemption
  • No reinvestment risk / price risk
  • May need to be re-balanced
• Barbell and Bullet portfolios

  In a bullet strategy, the portfolio is constructed so that the maturities of the securities in the portfolio are highly concentrated at one point on the yield curve

  In a barbell portfolio, the maturities of its securities are concentrated around one maturity
• Liability Driven Investment

  Match pension fund assets to obligations, usually using swaps and derivatives to hedge out inflation and interest-rate risk
• Riding the Yield Curve

  • Enhancing returns via yield curve positioning

  buying an undervalued 2-year bond, and hold for 1 year
• ESG

  Environmental Social Governance

  • Sustainability focused
  • Socially responsible investments: ethics, screens, shareholder advocacy
• History of ESG

  • United Nations
  • G20 Nations
  • Financial Stability Board
  • EU
  • US Trade Unions (1950s, 60s)
• Principles for Responsible Investment, 2006

  • ESG issues incorporated into investment analysis
  • Firms will incorporate ESG into their policies
  • Firms will seek disclosure on ESG issues from entities in which they invest